In light of the Enron verdicts, American attorney Kenneth Raphael analyzes some of the criticisms leveled against the Sarbanes-Oxley Act, the legislative response to the scandal.
While there were verdicts in the Enron case recently, the jury is still out with respect to the Sarbanes-Oxley Act.
In the aftermath of several corporate and accounting scandals, including Enron, WorldCom, and Tyco International, in 2002 the United States Congress passed, and President Bush signed into law, the Sarbanes-Oxley Act (also known as “SOX”) establishing new or enhanced accounting and reporting standards for all U.S. “public companies.” Under U.S. securities law, public companies (also known as “reporting companies”) are generally those which have a minimum of 300 shareholders or some public shareholders and assets of at least $5 million. All such companies are subject to the oversight of the U.S. Securities and Exchange Commission (“SEC”).
Among its numerous provisions, SOX provides standards for issues ranging from the creation of a public company accounting oversight board, auditor independence, corporate responsibility, and enhanced financial disclosure. Chief among its provisions is Section 404 which requires the creation of extensive policies and controls within public companies to secure, document, process, and verify material information dealing with financial results. It requires that each annual report filed with the SEC contain an internal control report which states management’s responsibility for establishing and implementing adequate procedures for financial reporting. This report must include an assessment of internal control structures and procedures and disclose the existence of any code of ethics which has been adopted. The accuracy of the report must be personally certified by the company’s Chief Executive Officer and its Chief Financial Officer.
Section 404 has proved to be controversial, primarily because its cost of implementation has been higher than anticipated. Although SOX does not contain any specific information technology (“IT”) requirements it has, in practice, required extensive IT modifications, particularly with respect to updating information to comply with the control and reporting requirements. According to a survey of companies with average revenue above $5 billion conducted by Financial Executives International, the costs of compliance have averaged more than $4 million. The costs for smaller companies are generally believed to be disproportionately higher.
Several industry groups believe that Section 404 compliance can cost smaller businesses (e.g. those with 250 or fewer employees) $500,000 or more per year for auditing and IT costs. Based on a recent study which analyzed proxy statements of more than 700 public companies, audit fees for companies in the Standard & Poor’s Small Cap 600 Index increased an average of 84 percent in 2004, while companies in the Standard & Poor’s Mid-Cap Index rose by 92 percent.
Thus, as a direct result of SOX, the cost of doing business for a U.S. public company has substantially increased. In many cases this has had a particularly adverse effect on foreign (non U.S.) companies that are publicly listed on U.S. stock exchanges.
As a result, many foreign companies are reconsidering whether their shares should be traded in the U.S. For example, there are approximately 300 European companies whose equity or debt are traded in the U.S. Several are now evaluating whether it makes sense to be listed in the U.S. at all. In addition to the high costs of compliance, they have taken note of the fact that U.S. institutional investors are increasingly willing to invest on European markets. In fact, since 2002 new U.S. market listings have declined by approximately 10 percent and some have attributed this in significant part to foreign-based companies.
However, the U.S. stock markets are unlikely to see an immediate mass exodus of international companies in the near future since those markets still represent the world’s largest pool of market capital. Also, even if companies delist their shares they will still have to comply with SOX until they can prove that they have fewer than 300 US shareholders.
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